Meme stocks have been a unique storyline of 2021: The "average Joe" managed to pull one over on Wall Street, and "average Joe" investors, in some cases, have made incredible amounts of money. Movie theater chain AMC Entertainment Holdings (NYSE: AMC) is symbolic of the meme stock movement and maintains a cult-like status with investors to this day.
But it's essential to point out the biggest mistake that AMC investors might be making, which is mistaking conviction to hold a stock with blind faith. AMC has some red flags that investors should consider as they hold on for dear life (HODL).
A lesson in dilution
The bull case for AMC is simple at first glance. It's a redemption story, a business on the brink of ruin that fought back through the pandemic on the back of supporting shareholders. As life returns to normal, the company will return better than ever as people start going to theaters again.
Image source: Getty Images
But what AMC did to survive is packed with details that are overlooked or misunderstood by many retail investors, so let's dive into what dilution is. AMC had to raise a lot of money to keep the company alive while theaters were closed; it did this by issuing new shares of stock.
AMC Shares Outstanding data by YCharts
Just how many shares were issued? The company's total number of outstanding shares increased roughly fivefold during the pandemic, to nearly 514 million. When a company issues new shares, it's a zero-sum game. The money doesn't fall out of the sky; it decreases the value of existing shares. This is called dilution.
Think of it as a pizza cut into four slices. If you cut the same pizza two more times, you now have 16 smaller portions; the overall size of the pizza doesn't change. So by increasing the number of shares by five times, AMC has made each previously existing share represent an 80% smaller stake in the business.
The company's earnings per share decrease (profits spread out across more shares of stock), so the market tends to adjust for this by trading shares lower. The previous share price almost doesn't mean anything when there is a lot of dilution going on, because shares should be trading much lower to reflect the extra shares.
Can valuation defy gravity?
The increased share price and additional shares have pushed AMC's market cap well above its pre-pandemic size. Once hovering around a $1 billion valuation, AMC's now worth more than $12 billion in market cap.
AMC Market Cap data by YCharts
When a stock's valuation is so far from its previous "normal," an investor needs to determine whether this is justified or not. If the answer is no, the stock is likely to revert toward its norms eventually. A cult-like stock can temporarily defy this gravity, so to speak, but if there is no fundamental support from the actual business, things can get ugly when the sentiment around the stock goes bad. If AMC were to revert to its previous market cap with all of these outstanding shares, the share price would likely be in the low single digits; AMC would become a penny stock.
Is AMC a healthy business moving forward?
The good news for AMC is the company's newfound reserves of strong liquidity, which is roughly $1.6 billion in cash equivalents as of its 2021 third quarter. The business has burned through $714 million through the first nine months of 2021, but 2021 Q3 saw a slow down in cash burn, to just $138 million. The quarter was the first since 2019 Q4 that AMC was completely open for business, so as long as theaters stay open, AMC shouldn't burn cash so quickly moving forward.
It's a big question whether people will return to pre-pandemic theater habits. This has been a bit of a challenge during the year, and with the omicron variant now spreading, it could keep theaters from filling up.
Theaters have overhead costs like staff, food, and utilities to pay whether the theater is half-empty or full. AMC was not profitable before COVID, posting a $149 million loss in 2019 and just a $110 million profit on more than $5 billion in revenue in 2018.
AMC will likely post losses again this year, so investors will need to look for a trend toward sustained profits over the next several years. The uncertainty of whether AMC will be able to do this makes it a risky stock that I believe may have a hard time supporting its inflated market cap in the long run.
The recent price drop is a warning flag, not an invitation to load up on AMC shares. Betting the farm on AMC today would be a big mistake.
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Justin Pope has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
